A Major Uranium Supply Gap Is Looming: Ed Sterck

The Energy Report: Why is the uranium market still down more than a year after the Fukushima accident?

Edward Sterck: While the uranium price is lower than it was immediately prior to Fukushima, it's important to remember that it is at a higher level than we saw in mid-2010, which was only six months before Fukushima. At that time, the uranium price was in the mid- to low-$40s, and we're now in the mid- to low $50s. From that perspective, I think the market is looking more robust than it did in 2010 despite the impact of Fukushima.

Uranium prices appear to have established a base in the mid- to low-$50s, but are now drifting along without any particular inclination to head higher. The main things keeping a brake on uranium prices are the current supply-demand balance and also some residual uncertainty regarding Japanese reactor restarts and the issuance of new reactor licenses in China, which were suspended after the Fukushima accident. I think we could see some positive news on both fronts in the not-too-distant future.

It looks increasingly likely that Japan will begin to restart reactors. Local opposition to reactor restarts was overcome last week, and the government appears to be getting closer to a definite restart decision, although the exact timeframe remains unknown.

"While the uranium price is lower than it was immediately prior to Fukushima, it's important to remember that it is at a higher level than we saw in mid-2010, only six months before Fukushima." Ed Sterck

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In China, some nuclear regulators have come out publicly over the course of the last few months, saying that they will begin to issue new reactor licenses again, potentially as early as June. We could possibly see those licenses issued fairly shortly. In addition, at the beginning of June, the Chinese cabinet reportedly reconfirmed the country's commitment to its nuclear program, although exact details are yet to be released.

In summary, Japan and China's unfolding nuclear policies are potential catalysts we may see in the near future. These two short-term catalysts may not necessarily result in an increase in the uranium price, but I view them as being potentially positive for uranium stocks. Such events may derisk the outlook for the nuclear industry in the investment community, and therefore for uranium demand. This could draw capital back into uranium stocks and potentially result in a rerating of the market valuation multiples applied to them.

TER: Could a catalyst like the end of the reprocessing program in Russia turn the prices up again?

ES: The downblending of Russia's highly enriched uranium, derived from decommissioned Russian nuclear weapons, ends at the end of 2013. The so-called Megatons to Megawatts program currently produces the equivalent of about 23 million pounds (Mlb) per year. Although it's possible Russia may continue to downblend some material for internal purposes or sell its reactor technology to third-party countries, the resulting production will be greatly reduced. Even in 2013, the last year of the current deal, the quantity of material available to the market is expected be somewhat lower, at around 16 Mlb. However, the impact of that is somewhat difficult to ascertain with absolute certainty.

"We're already coming into the timeframe where the Russian material is all spoken for." Ed Sterck

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The program's output does represent a fairly large part of the marketaround 12% of annual uranium demand. As such, one would expect some price appreciation after that material is no longer available to utilities. However, when you look at the procurement process for nuclear fuel, the utilities typically look at supply levels 18+ months ahead. So we're actually already coming into the timeframe where the Russian material is all spoken for, and the utilities should need additional sources of material from 2014 onward. But we haven't really seen a huge price movement to reflect any supply-demand shortfall there.

It's probably fair to assume that the increase in production from various parts of the world, particularly Kazakhstan, has been sufficient to offset the Russian material, at least for the time being, although we could see a supply-demand deficit opening up in the years after 2014.

TER: Given what you've said about China and Japan, will things pick up in the market over the summer? Or is it going to take a little longer than that to bounce back?

ES: The summer is traditionally a very quiet time in the nuclear space, as it is in capital markets in general. It's possible we could see some movement toward the end of the summer, but I think the world is still somewhat fixated on the uncertainty surrounding the Eurozone and the broader macroeconomic impact that any continued problems with the Eurozone might have. Until those are resolved, it's very difficult to make absolute calls on these sorts of things.

TER: Quite a few of the uranium stocks are down right now. Is this going to make them ripe for acquisitions?

Most of the current producers are already currently spoken for, with the exception of Paladin Energy Ltd. (PDN:TSX; PDN:ASX). The other major listed producers have significant shareholders who can block any takeover acquisition, whereas Paladin has a broad shareholder base. In addition, its balance sheet is looking a little bit stretched at the moment and this could make the company vulnerable.

There are a couple of others out there that could be of interest. Denison Mines Corp. (DML:TSX; DNN:NYSE.A) is one. It has a couple of interesting projects, one in the Athabasca area with the Wheeler River project, on which it has a joint venture with Cameco Corp. (CCO:TSX; CCJ:NYSE). Cameco owns about 30% of that joint venture. Denison also has the Mutanga project in Zambia, which already has its mining license but probably needs to undergo some further exploration to develop critical mass. In addition, Denison has a 22.5% interest in the McLean Lake mill operated by AREVA (AREVA:EPA) at present.

TER: What about Bannerman Resources Ltd. (BAN:TSX; BMN:ASX)? It backed away from a cash offer from China's Sichuan Hanlong last year, but in your January interview, you told us it was still talking to some other potential buyers. Has the feasibility study that it has completed for Etango in Namibia changed things? Could these talks send the price up?

ES: We haven't really heard anything more on the talks from them. Bannerman has completed all of its technical and environmental studies. I suspect the company is probably in the process of consulting with various parties and seeing what interest there might be out there, but there is nothing specific in the market.

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"Given the current valuations, it's possible we could see some consolidation." Ed Sterck

TER: Did that feasibility study show it would be viable?

ES: The feasibility study showed that the project is economic, but that it probably needs higher uranium prices, upwards of $70/lb, for it to be a viable stand-alone entity in current market conditions. Bannerman's primary project is the Etango project in Namibia. Its metallurgy is similar to Rio Tinto's Rössing operation, which is not too far to the north, and also similar to what was Extract Resources' Husab. The problem that Bannerman faces is that it appears to be just a little bit too low grade at current uranium prices.

For its share price to appreciate, Bannerman probably needs to see an element of merger and acquisition (M&A) interest. One of the interesting things about the Etango project is that although it's low grade and doesn't appear to be economic at least on my current estimates at existing uranium prices, it could be of interest to a strategic parastatal (quasi government-owned) organization. I think this is one of the reasons that the company has had discussions with various Chinese and other Asian groups in the past, the reason being that if you're a parastatal organization, possibly out of China, with a low cost to capital, then obviously the economics of the project are quite different. It has a very large resource base. So from a strategic perspective, it could be interesting.

TER: Which companies do you think will be hunting for bargains with the stocks down? Cameco plans to raise some money, so is it on the prowl right now? Which companies may be of interest?

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ES: Cameco has just filed a short-form shelf prospectus. That doesn't necessarily mean it's actually going to raise money. I think it is just putting things in place to give itself some flexibility if it does decide to make a move. Cameco also has a strategy to double uranium production organically by 2018, for which it will need a certain amount of capital. But it should be able to fund the bulk of its needs from operational cash flow. The shelf prospectus just gives it some flexibility if there are any capex overruns or if it does want to consider making acquisitions.

Paladin may be of interest to Cameco, because it has two projects that are mostly technically derisked. It offers about 8 Mlb/year in production straight off the bat. Given the fact that its balance sheet is a bit stretched at the moment, it's possible that it could be vulnerable. The enterprise value is about $1.7 billion, so it would definitely be at the top end of what Cameco may be able to afford. Beyond Paladin, Denison, as I mentioned earlier, could also be of interest. Additionally, it is worth highlighting that while Paladin may demonstrate M&A appeal, the stretched balance sheet also means that potential investors could be faced with a liquidity event at some point in the future.

TER: Paladin experienced a labor strike in Kayelekera. Production was back up again in May, but could the strike further impact the company?

ES: I don't think it's going to have a significant impact. Paladin experienced around five days of reduced production at about 65% of normal capacity, so I don't expect the strike to significantly dent output unless there have been further issues that have not yet been publicly reported. However, Paladin has been fairly upfront about all of this, so I'm not really expecting any significant surprises there.

TER: In FYQ3, Paladin had a loss of $18 million. How is it going to do in Q4?

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ES: We are expecting it to achieve breakeven in Q4. Looking into next year, I'm expecting it to move into a very modest profit over the course of the subsequent four quarters of the next year.

TER: What will propel Paladin's climb back into the black?

ES: Reducing operating costs at Kayelekera and perhaps tweaking the operating costs at Langer Heinrich may become a focus. However, the principal problem that Paladin faces is servicing its debt, because it's quite leveraged. The interest payments are pretty much offsetting the profitability from the mining assets at present, so restructuring its balance sheet is probably a priority for it to move toward sustained profitability.

TER: Aside from Cameco, are there other companies looking for bargains to pick up?

ES: If we look at the list of uranium producers, Uranium One has the option to buy the Mkuju River project off ARMZ, so I think from its perspective, it already has a fairly comprehensive pipeline of potential projects it could develop. I'm not necessarily sure that it would be going after or making any major acquisitions. Paladin's balance sheet probably couldn't support an acquisition currently, so I think that it will be focusing on its existing portfolio of projects and trying to pay down its debt position, perhaps focusing on reducing costs at Kayelekera. Then, if we look at Energy Resources of Australia Ltd. (ERA:ASX), a one-asset company majority owned by Rio Tinto, I think it's unlikely that it would be out making acquisitions. Cameco is really the most likely consolidator as I see it.

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TER: Where will Cameco look to expand capacity?

ES: Its plan is to double production from around 2040+ Mlb by 2018. The biggest component of that is Cigar Lake, which is gradually coming close to first production. Cameco's target is first production in mid-2013. I think the first tangible commercial production will probably take place in 2014. That should provide about 9 Mlb/year for Cameco on an attributable basis. Cigar Lake is largely funded already, although there is some capex still to be spent over the course of the next couple of years. For the remaining 11+ Mlb that Cameco would be looking to grow, Inkai in Kazakhstan is one possibility. It has the potential for production to be doubled there, but that depends on whether the company obtains the various licenses from regulators in Kazakhstan. Then Cameco also has the Kintyre project in Australia, for which it completed a prefeasibility study, but it hasn't released very many details as yet.

TER: Thank you for your time, Ed.

Edward Sterck covers uranium, diamond and platinum group metal mining companies for BMO Capital Markets. He joined BMO in 2007, prior to which he was a mining analyst at Hargreave Hale. Before working in mining research, he spent more than four years trading government bond futures on a proprietary basis. Sterck holds a Bachelor of Science in geology with honors from the Royal School of Mines, Imperial College London.

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